Exchange-traded funds, which combine features of both stocks and mutual funds, continue to be one of the hottest investment products on Wall Street. But how much do you really know about them? Here are 10 things that may surprise you:
1. ETFs aren't new. Canada claims the first exchange-traded fund, but first U.S. ETF launched in 1993: S&P 500 Depository Receipts, also known as SPDR and pronounced "spider." While the first wave of ETFs tended to track broad market indexes, such as the S&P, the current generation slices and dices the market by industry, country, and sometimes obscure niches. HealthShares Infectious Disease ETF, anyone?
2. Their proliferation isn't completely abnormal. Worldwide, the ETF industry is approaching $800 billion in assets (70 percent of those assets are in the United States) in more than 1,100 funds, according to Morgan Stanley. But consider that between 1984 and 1994, more than 4,000 mutual funds were launched. "[The growth of ETFs is] very consistent with what you would have seen in the mutual fund business during its growth phase," Bruce Bond, president of PowerShares Capital Management, said at the Investment Company Institute conference in Washington, D.C., last week. Granted, mutual funds were slower growing in the beginning: It took 45 years for mutual funds to reach $600 billion in assets and five more for their assets to reach $1 trillion. According to Morgan Stanley, ETFs are on track to surpass that $1 trillion mark in the first quarter of 2009.
3. Despite their fast growth, ETFs still claim a relatively small slice of investors' dollars. At the end of 2007, assets in U.S. exchange-traded funds stood at just over $600 billion, while U.S. mutual funds held $12 trillion in assets, according to the ICI.
4. A handful of companies hold most of the ETF money. The top four ETF sponsors—Barclays, State Street, Vanguard, and PowerShares—account for 75 percent of all ETF assets.
5. Low expenses are a huge draw of ETFs, but not all fees are reasonable. Simply put, low expenses are a head start to higher returns. As the Motley Fool points out, sometimes funds charge significantly different fees for essentially the same holdings: the iShares MSCI Emerging Markets ETF charges annual expenses of 0.75 percent, for example, while the Vanguard Emerging Markets ETF charges just 0.30 percent. Fool breaks it down: "In case you're thinking that a 0.45 percent difference isn't such a big deal, let's imagine that you have $10,000 invested in each of the ETFs, and that they each earn an annual average return of 10 percent per year for a decade. Subtracting the fees, they'll earn 9.25 percent and 9.7 percent, respectively. The iShares ETF will grow to $24,222, while the Vanguard ETF will grow to $25,239. That's a difference of more than $1,000!"
6. ETFs aren't ideal for dollar-cost averaging. Although ETF fees are generally minimal, trading costs can throw a wrench in your plan to invest often with small dollar amounts. Your best bet is to use a broker that offers free trades if you maintain a minimum balance, such as Zecco (which offers 10 free trades per month if you have $2,500 in your account).
7. ETFs are a way for average-Joe investors to play sophisticated strategies. You can take bearish positions or execute your own hedging strategy by investing in an ETF that bets on the decline of an index, investing style, or sector of the market. For example, ProShares' short-selling ETFs produce inverse returns of a particular index, such as the Short Dow30, which bets against the Dow Jones industrial average. (So, if the Dow loses 10 percent, the Short Dow30 should gain 10 percent.)
The firm also offers a line of "ultra" funds, which essentially give investors double the return (or double the inverse) of an index's daily gain. Bullish about oil? ProShares' Ultra Oil & Gas fund aims for daily results that double the performance of the Dow Jones U.S. Oil & Gas index. Recently, Direxion Funds filed a proposal with regulators for funds that offer three times the performance (or the inverse) of an index. Although these funds aren't as risky as pure short-selling—in which you could lose more than you invested—they should be approached with caution.
8. ETFs are gunning for your retirement money. Exchange-traded funds have yet to make a big dent in the 401(k) market, which is dominated by mutual funds. But that will soon change, Jonathan Steinberg, chief executive officer of WisdomTree Investments, said at the ICI conference. The firm recently launched an ETF platform for 401(k) plans. "This is one of the last areas of the asset management world that has not yet broken down," he said. "You may find some initial resistance, but ETFs are really compelling. Once they start, they'll wear everyone down." Sponsors are also marketing target-date ETFs.
9. This is just the beginning for actively managed ETFs. The next big trend in this industry is actively managed ETFs, which aren't tied to an index like traditional exchange-traded funds. Instead, they hinge on manager skill. Companies including Bear Stearns and PowerShares have already launched actively managed ETFs, and plenty more are on the way. "The floodgates, we understand, are just about to open on actively managed ETFs," writes Jim Wiandt of IndexUniverse. It's too soon to tell if active ETFs will be a smashing success, but the industry is "working harder, faster, and the rate of change will be exponential. There is no end in sight," Steinberg said.
10. Many ETFs will live, but some will die. The booming ETF industry is fiercely competitive, and some funds (particularly those that track narrow sectors or industries) never gain traction with investors. Earlier this year, Claymore Securities dropped 11 ETFs from its lineup because they failed to attract much money. The flops included Claymore/KLD Sudan Free Large-Cap Core, Claymore/Robeco Developed World Equity, and Claymore/Clear Global Vaccine.